Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Risk Management: An
Introduction to Financial
Engineering
(^826) © The McGraw−Hill
Companies, 2002
Suppose you buy the November 80 orange juice futures call option. You will pay
$.024 per pound for the option (they’re actually sold in multiples of 15,000, but we’ll ig-
nore this). If you exercise your option, you will receive a futures contract on orange juice
and the difference between the current futures price and the strike price of $80 in cash.
Hedging Exchange Rate Risk with Options
Table 23.2 shows that there are futures options available on foreign currencies as well
as on commodities. These work in exactly the same way as commodities futures op-
tions. In addition, there are other traded options with which the underlying asset is just
currency rather than a futures contract on a currency. Firms with significant exposure to
exchange rate risk will frequently purchase put options to protect against adverse ex-
change rate changes.
Hedging Interest Rate Risk with Options
The use of options to hedge against interest rate risk is a very common practice, and
there are a variety of options available to serve this purpose. Some are futures options
like the ones we have been discussing, and these trade on organized exchanges. For ex-
ample, we mentioned the Treasury bond contract in our discussion of futures. There are
options available on this contract and a number of other financial futures as well. Be-
yond this, there is a thriving over-the-counter market in interest rate options. We will de-
scribe some of these options in this section.
A Preliminary Note Some interest rate options are actually options on interest-
bearing assets such as bonds (or on futures contracts for bonds). Most of the options that
are traded on exchanges fall into this category. As we will discuss in a moment, some
others are actually options on interest rates. The distinction is important if we are think-
ing about using one type or the other to hedge. To illustrate, suppose we want to protect
ourselves against an increase in interest rates using options; what should we do?
We need to buy an option that increases in value as interest rates go up. One thing we
can do is buy a putoption on a bond. Why a put? Remember that when interest rates go
up, bond values go down, so one way to hedge against interest rate increases is to buy
put options on bonds. The other way to hedge is to buy a calloption on interest rates.
We discuss this alternative in more detail in the next section.
We actually saw interest rate options in Chapter 7 when we discussed the call feature
on a bond. Remember that the call provision gives the issuer the right to buy back the
bond at a set price, known as the call price.What happens is that if interest rates fall, the
bond’s price will rise. If it rises above the call price, the buyer will exercise its option
and acquire the bond at a bargain price. The call provision can thus be viewed as either
a call option on a bond or a put option on interest rates.
Interest Rate Caps An interest rate capis a call option on an interest rate. Suppose
a firm has a floating-rate loan. It is concerned that interest rates will rise sharply and the
firm will experience financial distress because of the increased loan payment. To guard
against this, the firm can purchase an interest rate cap from a bank (there are banks that
specialize in such products). What will happen is that if the loan payment ever rises
above an agreed-upon limit (the “ceiling”), the bank will pay the difference between the
actual payment and the ceiling to the firm in cash.
Aflooris a put option on an interest rate. If a firm buys a cap and sells a floor, the re-
sult is a collar.By selling the put and buying the call, the firm protects itself against
800 PART EIGHT Topics in Corporate Finance
The Association of
Corporate Treasurers
(www.treasurers.org) has
lots of information on a
variety of subjects,
including risk
management.